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DULUTH, Minn.—The Duluth school district is almost out of reserve cash.

While the amount is not final, district CFO Doug Hasler said remaining funds are about $111,000, down from $2.4 million the prior year. An increase in special education costs for district resident students enrolled elsewhere is contributing to the decline in reserves, Hasler said.

The district is directed by state law to pay most of those costs, and Hasler said that last year there wasn't enough revenue from the state to do it. Statewide, districts struggle to pay for increasing special education services mandated by the state and federal governments but not funded to the levels of need. In what's called a cross-subsidy, Duluth typically spends $8 million of its general fund to make up the difference. A chunk of that goes outside the district and Duluth Edison Charter Schools, with the most Duluth district resident students, gets the largest portion — in 2013 it was $1.7 million and in 2017 it was more than $2 million.

But that's not the only reason Duluth's reserves are a fraction of what they once were. Some properties left over from the long-range facilities plan — like the valuable former Central High School property — remain unsold, and some didn't garner the payout anticipated. Those sales were meant to bolster a reserve fund that in 2010 was $15 million.

The use of reserves to pay down construction debt in the absence of school sales also dragged down the amount.

The low reserve amount triggered a credit rating downgrade from the Moody's bond rating service Wednesday, moving the district into a higher-risk category. The reserve fund and declining enrollment related to charter school competition were cited by Moody's as reasons for the downgrade. (The state allocates funds to public schools based on their enrollment, and Duluth has about 8,300 students this year. In 1995, district enrollment was 14,000.)

The district, set to borrow about $4 million short term to in part pay for renovations of the former Rockridge Elementary School, was given a new credit assessment as part of that process. The district was downgraded in 2013 for similar reasons.

Bonds related to the long-range facilities plan have fixed rates, so the rating won't affect them. But it does mean future borrowing will have higher interest rates, although not as high as for commercial borrowing.

For Moody's Investor Service, the highest bond rating of Aaa indicates low credit risk to an investor; the lowest rating, a low C, means obligations are typically in default with little prospect of recovery. Moody's, one of the top three bond rating businesses along with Standard & Poor's and Fitch Group, does financial research on bonds issued by commercial groups and government.

The Duluth district's new Ba1 rating means substantial credit risk to an investor, according to Moody's. The rating was formerly Baa2. By comparison, the similar-sized St. Cloud school district has a rating that falls into a low credit risk category. Hermantown, which recently borrowed money for a building project, also falls into a low-risk category.

The underlying issues that triggered the downgrade need to be addressed, Hasler said, and he expects it to be a topic of discussion for the School Board in November. He pointed to the district's rare boost in enrollment this fall, and is hopeful the trend will continue.

But the low reserve amount could lead to cash flow problems for the district.

Board member Alanna Oswald said the board has a policy to maintain in reserve 10 percent of its general fund. That hasn't been enforced by Superintendent Bill Gronseth, she said, noting her understanding is that the district will lobby the state to change special education funding mandates to avoid future similar issues.

"We need to rebuild our budget and how we spend the community's money to increase our bond rating as soon as possible," Oswald said.

Member Nora Sandstad said public school districts have for years had to pay for charter school special education spending, despite no publicly elected board holding those schools accountable.

"This problem has existed in statute for years, but the recent hit to our budget, and consequently our bond rating, resulted from this year's cross-subsidy bill coming in at over $1 million higher than in prior years," she said. "The state Legislature must ensure charter schools are made accountable to the public and held responsible for their own spending."

Duluth Edison head of school Bonnie Jorgenson said Thursday night that special education expenses are held to a "high level of scrutiny and cover expenses that meet the needs of students within state and federal requirements."

"We have successfully completed a Minnesota Department of Education audit related to our special education costs," she said. "Blaming their bond rating on this area of our budget is an argument without merit."